Download the relationship between foreign direct investments and economic

European Integration Studies, Miskolc, Volume 4. Number 1. (2005) pp. 135-142.
THE RELATIONSHIP BETWEEN FOREIGN DIRECT
INVESTMENTS AND ECONOMIC POLICY
VIOLETTA FODOR
Institute of Economic Theories, University of Miskolc
3515 Miskolc-Egyetemváros, Hungary
[email protected]
Field of research: foreign direct investments
Abstract: Governments try to attract FDI for expected beneficial effects on employment, wages,
balance of payments, technology and growth. The invest target places become more similar in
regions, so some kind of investment motivation and regulatory means are appreciated. Investment
attracting came to the front and started a competition of motivation between countries.
Introduction
There are different definitions for the Foreign Direct Investment, let see two from them:
FDI stands for Foreign Direct Investment, a component of a country's national financial
accounts. Foreign direct investment is investment of foreign assets into domestic structures,
equipment, and organizations. It does not include foreign investment into the stock markets.
Foreign direct investment is thought to be more useful to a country than investments in the
equity of its companies because equity investments are potentially ’hot money’ which can
leave at the first sign of trouble, whereas FDI is durable and generally useful. FDI usually
means an investment abroad where the company being invested in is controlled by the
foreign corporation.
The purpose of economic policy in attracting foreign capital
Governments try to attract FDI for expected beneficial effects on employment, wages, balance of payments,
technology and growth. It is worth looking over how far the positive effect offsets the cost of the allowance, which
comes forward in the host country during the investment (Sass 2003).
In general most governments see FDI as having greater potential to improve total factor productivity than an
equivalent amount of domestic investment. This would be taken as axiomatic in developing and transition
economies and depending on the origin of the multinational firm, at least in some developed economies. Add to
this the potential spillovers from multinational firms to domestic firms that are believed to raise their productivity,
yielding a second growth bonus and it becomes clear why attracting inward investment figures prominently in the
policy priorities of so many goverments. This leads naturally to three questions: Can active policy intervention
influence the level and composition of inward investment? Can particular policies maximize the potential for
spillovers, both by encouraging multinationals to transfer technologies and by improving the absorptive capacity
of domestic firms? Do target policies yield net benefits? (Görg-Greenaway 2004)
The invest target places become more similar in regions, so some kind of investment motivation and regulatory
means are appreciated. The role of motivation is most important where the investor needs to chose from places
with similar conditions in national or regional level. (Sass 2003) Although there is some evidence that investment
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incentives can affect the location choice of multinationals, the effect appears to be small. (Görg-Greenaway 2004)
Invest attracting came to the front and started a competition of motivation between countries. The motivation
competition is rising, it is seen, that the pork bassel per workplace created by FDI is setting higher. (Sass 2003)
The Hungarian economic policy today is suitable for motivating new capital investments.Trade policy is relevant.
In general, economies with more open trade regimes have done better at attracting FDI and benefiting from it than
counties with inward-oriented regimes. (Görg-Greenaway 2004)
It would be important to improve the general investment environment and improve the foreign capital attracting
ability, on the one hand to make end of macroeconomical imbalance, on the other hand improvement with
infrastructure and education. It is worth considering to manage the gain tax-key like a capital attracting asset and
to lower the tax and incidental experiences and local taxes as well. The investment motivation claims a reform:
only one organisation is needed to be formed, which concentrates only on the investment motivation and it has an
autonomous decide tether. This organisation should have a coordinator role in the administration of the
allowances. (Sass 2003)
The question is whether governments can implement policies to maximize the prospects for extracting benefits
from multinational firms. General policies may turn out to be the most effective means of boosting the probability
of positive spillovers.
FDI is a key driver of economic growth and development. Most governments consider the attraction of FDI as a
priority, particularly in developing and transition economies. It is given this emphasis not just because it boosts
capital formation but also because it can enhance the quality of capital stock. The reason is that multinationals are
assumed to bring with them best practice or, as a minimum, better practice technology and management. Moreover
it is possible (even probable) that a given multinational firm will not be able to protect its superior technology or
management fully to prevent some elements from being absorbed by indigenous firms. If spillovers occur, they
provide an external benefit from FDI one that goverments are hoping to secure. But this could as well happen that
researchers are looking in the wrong place and with the wrong lens. Many studies focus on the industry rather than
on the firm or plant.
Consensus in the policy literature is also clear: general policies aimed at altering the fundamentals are more
important than specific policies aimed at attracting particular investments. Such specific policies seem to affect
primarily the distribution of rents. Governments compete in offering investment incentives and in the process
create rents for multinational firms.
Both econometric evidence, surveys and case study work suggest that the characteristics of the economic
environmnet are generally much more important: infrastructure, local labor market conditions, reliability of
communications systems, as well the overall macroeconomic and trade policy climate. (Görg-Greenaway 2004)
Summary of the FDI motivation assets
The investment motivation assets improve the return of investments or reduce the cost and the risk. Motivations
can be fiscal, financial and other motivations. These are summarised in the following table. These allowances
influence the place selection of the new investments above all. In most cases governments require to allowances
different conditions and requirements to turn the investments to stressed sectors, activities and regions. (Sass
2003)
Types of
motivation
Budgetary
Financial
Their purposes
Their elements
Reducing
the
tax
burden for the investor
Tax allowance, tax exemption, tax refund,
relief from customs duties, reducing on tax
base, reducing VAT, quickly depreciation
allowance, renvestment allowance, deficit
distance
preferential
credits,
non-refundable
To
give
a
direct
The relationship between foreign direct investments…
financial allowance
Other
Improving
the
expected profit of the
investment/ reducing
its costs with nonfinancial assets
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allowances, state guarantee for investment
credits, exportguarantee insurance and
credit, different target allowance
preferential governmental contracts, cheaper
real estate than the market price,
institutional investment motivation, smalland medium sized enterprices’ development
programs, duty free zones, special economis
zones, industrial parks
Table 1. The most important FDI motivations in the narrow sense
(Sass 2003)
The role of FDI in distribution
FDI is not usually or at least has not recently been concerned with effects on inequality or
poverty. Furthermore, FDI is only one of many factors affecting skill- specific wages and
wage inequality. In general, FDI may have most an effect on those in the middle of the
income distribution and little effect on those at the bottom. The effect may be to bring some
in the middle closer to the top group reducing inequality, but further from the bottom,
increasing inequality. Emphasis here is not on policies towards inequality or the poor per
se, but about policies to ensure greater and more equally distributed gains from FDI.
The best policies are those that increase the potential for workers and for the economy to
benefit from FDI. The former policies are primarily related to education, training and
industrial relations. The latter are meant to encourage increased efficiency of domestic
firms, benefit from linkages with and spillovers from foreign firms, and attract FDI into
areas or sectors that are most beneficial for the poor.
Growth in FDI will increase the demand for skilled workers. Good quality and appropriate
education in this context requires increased enrolment in secondary education to provide the
foundation for vocational and tertiary technical education. Governments in developing
countries have tried various schemes to boost enterprise training but take-up and coverage
rates remain low. This is a case for public policy intervention as private firms may not have
sufficient incentives to train low-skilled workers. Foreign firms offer more training than
their local counterparts, and should be encouraged to offer more to low-skilled workers.
If governments want to ensure that some benefits of FDI go to the poor directly, they may
want to encourage foreign firms that employ relatively unskilled labour and/or attract
investment in sectors that are likely to benefit the poor. If FDI increases employment of
unskilled workers who were poor, it can reduce poverty while increasing wage inequality.
FDI that supports employment in rural areas and agricultural sectors is more likely to
benefit the poor, even if the gains are also unequally distributed.
As certain policies that directly affect FDI can help to ensure that all workers gain from
FDI, other, more indirect and more general policies are sometimes as effective or efficient.
There are various policy options through which the benefits of FDI can be made to reach
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The relationship between foreign direct investments…
the poor indirectly. These include maximising employment opportunities and learning
effects in local firms through promoting linkages within the guidelines set by international
regulations and using fiscal receipts of the foreign investment to spend on productive
infrastructure or social sectors such as education and health.
Policy influences on foreign direct investment
The most important effects on bilateral FDI patterns seem to come from border policies and
labour market arrangements. Detailed analysis shows that the contribution of border
policies is equally split between the impact of FDI restrictions and other openness factors,
such as participation in free-trade areas and tariff and non-tariff barriers. The labour tax
wedge is the most influential component of labour market arrangements, with employment
protection legislation playing a smaller role.
Outside free-trade areas, OECD estimates suggest that tariff barriers between the host and
investor country or between the host and third-party countries discourage foreign
investment. This reflects the costs that tariffs impose on re-importing to the home country,
or exporting to third-party countries, the final or intermediate goods produced by foreign
affiliates. Restrictions often set limits on investment by foreign companies, as well as on
management and organisational choices of foreign affiliates in the host country.
OECD empirical results suggest that labour market arrangement can influence the cross-country patterns of FDI as
strongly as direct restrictions to trade and FDI. These arrangements are generally driven by policy objectives that
are unrelated to FDI, but they have important side effects on the level and geographical allocation of FDI flows.
Strict employment protection legislation and, especially, high labour tax wedges appear to divert FDI to locations
where labour market arrangements are perceived as less costly. The negativ effects of strict employment protection
legislation on inward FDI may also be due to the fact that this legislation is likely to affect not only the returns
expected from foreign investment but also their variability, thereby increasing the risk that investors face in the
host country. Cost shifting for high labour-income taxation may be particularly difficult for multinational
enterprises, whose employees have a higher cross-country mobility, especially at highly-skilled and managerial
levels.
OECD analyses suggest that relative to the OECD average, policy influences on FDI appear to have played
different roles in different countries over the past two decades. For instance, while labour market arrangement
seem to have had a relatively positive influence on inward FDI positions in English speaking countries like Japan
and Portugal, they have tended to depress them in other Europan countries. Similarly, while the openness factor of
most European countries and the United States is estimated to have a positiv role, comparatively restrictive border
measures are likely to have depressed inward FDI positions relative to the OECD average in Canada, Australia and
to a less extent Japan, Norway and Finland. The contribution of product market regulation was significant for
countries having either a relatively liberal approach, where it pushed up relative inward FDI positions, or a
relatively restrictive approach, where it pulled down relative inward FDI positions.
While trade and FDI liberalisation have been extensive over the past two decades, further
opening up borders would increase FDI integration among OECD countries. This means a
country-specific reform, but tipically it would imply lifting screening requirements and
restrictions on foreign shareholdings, and substantially reducing other restrictions.
The OECD has analysed the effect of policies on FDI using a large data set that covers
bilateral FDI relationships between 28 OECD countries over the past two decades. The
focus was on three sets of policies: explicit restrictions to trade and FDI, regulations
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affecting domestic competition, and policies that affect labour costs and the adaptibility of
labour market. OECD countries’ policies in labour and product markets were proxied by
policy indicators. These were supplemented by indicators of non-tariff barriers and new
indicators of tariffs. The analysis accounted for a large number of non-policy factors,
including geographical distance, market size, transport costs, differences in the availability
of physical and human capital, and other country- and period-specific effects. The results of
empirical analysis can used to quantify the long-run effects of policies. The results of these
simulations are only suggestive of what could happen under different policy scenarios,
notably because the applied coefficients may be imprecise due to the difficulty of
disentangling the pure effects of policy and non-policy factors. Moreover, the estimated
models on which the simulations are based do not account for all possible interactions
between policy changes and FDI flows. The quantitative effects highlighted in these
simulations also partly depend on the configuration of policies and the distribution of FDI
positions.
Why is the attracting of foreign capital unsuccessful?
Without inviting foreign investors in some developing countries, foreign companies have
not responded to their invitations. The reason can be the political and economical instability
in the host country. The one reason is that objectives and organisational characteristics of
state-owned enterprises’ differ greadly, but it is possible to identify common factors. The
main reason in many less developed countries was a distrust of private enterprise, combined
with the socialist ideological beliefs. The Indian government explicitly stated its intention
to retain control over the ’commanding heights’. A related factor was the desire to
decolonise the country’s commercial sector. Many Latin-American countries strove to
avoid dependencia or the dominance of foreign economic powers.
Other characteristics of state-owned enterprises also influence the content of their
investment promotion materials. They have a much broader coalition of members than most
private enterprises, including their managers, boards of directors, goverment ministers, civil
servants, parliament and politicians. Their managers must take into account the
expectations and various interest groups. They are expected to balance the social as well as
the commercial costs and benefits of their projects with a much greater emphasis on the
social side than in private companies. Their goals and objectives tend to be broader more
than in private companies.
The characteristics of less developed countries are the high rates of unemployment, huge
disparities between rich and poor, the relative inefficiency and low purchasing power of
domestic market, the low levels of technology, and so on. In addition, many goverments are
influenced by the ’ideology of development’, a belief that the government has to take a very
active role in the country’s economy in order to hasten the pace of development.
At the personal level many managers in state corporations face career environment more
similar to civil service than to the result-oriented competition of American companies. The
environment may reward them for caution rather than risk-taking. There is a difference
concerning subordinates as well, in the American companies there is an assigned real and
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limited responsibility to quite junior trainees, in the large organisations in developing
countries often practice a kind of ’training by hanging around’, in which junior managers
are supposed to learn their jobs mainly by observation. Often they are given only small
tasks under close supervision until they have been with the organisation for several years. It
also makes top managers overloaded as they have to spend too much of their time
reviewing on minor matters. They may not be able to rely on their subordinates, so they
may not be able to devote sufficient effort and attention to the difficult and strategigally
important tasks of planning their organisations’ futures.
An important difference between American executives and state corporation managers in
LDCs is that the former tend to strive to increase their own and their organisations’ power
and independence, while the latter often deliberately subject their organisations to the
guidance and control of goverment ministries or boards. The managers of American
companies assume the bigger risk in the hope of bigger result, but managers of state owned
enterprises do not, because they want to avoid the possibility of any failure being attributed
to their own errors.
These cultural and environmental charactaristics strongly affect the language of documents
drafted by state corporation managers to attract and influence foreign companies. They are
afraid of foreign companies. Managers of the state owned companies often do not
understand the competitive atmosphere and the pressure for financial results that confronts
executives at all levels in American companies.
It would be a long, slow and difficult process to try to change the ingrained attitudes and
practices of the State owned enterprises to make their investment literature more marketingoriented. However, they know the way how to introduce news without great changes in the
organisational culture. They see only the following: ’what you must do for us’, rather than
’what we can do for you’. The least developed country has to be concerned primarily with
its own welfare, with obtaining the coming foreign capital. But that country should be more
effective in attracting desirable capital.
Another problem is that the corporations owned by the state do not understand prospective
investors’ needs, and leave the saying out of consideration: ’You catch more flies with
honey than with vinegar.’ They would be better to welcome to all proposals. It should
communicate its eagerness to make it easy as possible for foreign companies to follow
through on their plans. This does not mean that hospitality of the corporation or the country
should allow itself to be exploited or abused by foreign companies. The question is,
whether state rules make good policy, as rules are intended to guard against financial and
other abuses which the country may have suffered in the past, while on the other hand they
may well be less necessary as the local economy becomes more developed and the
government’s regulatory powers grow more sophisticated.
Corporation personnel would not be involved in the formative stages of the project, but
would only see the completed documents. They would consider only one proposal at a time
if several were to be submitted. They need to understand the competitive bidding so it is
quite possible that confidence comes from the state owned corporations’ managers.
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For several reason this is not the best way. Proposal evaluation is too important to be
slighted in this way and careful attention should produce some good rewards. They could
have much more confidence in a feasibility study. Finally they would want to have some of
their own people working with the prospective investor while the study is being carried out.
Otherwise, it is too easy for the investor to manipulate the study so as to make the proposal
look better for the host country than it really is. If the management were overloaded, they
could assign more junior people to work intensively with the foreign company.
Having submitted one investment proposal at a time also has many disadvantages. Maybe
the state owned enterprises’ people would be better able to recognise the strengths and
weaknesses of a given proposal if they took the time to work through several of them and
could compare them. They can increase their ability to bargain for better terms if they had
proposals from several competing foreign companies (Stoever 1989).
References
GÖRG, H. –GREENAWAY, D. (2004) Much Ado About Nothing? Do domestic Firm Really Benefit
from Foreign Direct Investment? Research Observer, Oxford University Press, (2004/2)
pp. 191-197.
SASS, M. (2003) Versenyképesség és a közvetlen külföldi működőtőke-befektetésekkel kapcsolatos
gazdaságpolitikák in: PM Kutatási Füzetek Nr. 3. September.
www.pm.gov.hu/Dokumentumok/Seo/fuzetek.html (20th December 2004.)
STOEVER, W. A. (1989) Why State Corporations in Developing Countries Have Failed to Attract
Foreign Investment, Internatonal Marketing Review
http://web24.epnet.com/ (2nd April 2005.)
Foreign Direct Investment: Who Gains? Briefing Paper, (2nd April 2005.)
http://www.odi.org.uk/publications/briefing/bp_may02.pdf (2nd April 2005.)
Policy influences on foreign direct investment OECD Economic Outlook 73.
http://www.oecd.org/dataoecd/24/31/2956472.pdf (2nd April 2005.)
http://economics.about.com/cs/economicsglossary/g/fdi.htm (2nd April 2005.)
www.investopedia.com/terms/f/fdi.asp (2nd April 2005.)
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